10.22.08 - ECONOMICS 1 Professor Kenneth Train 10/22/08...

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ECONOMICS 1 Professor Kenneth Train 10/22/08 Lecture 16 ASUC Lecture Notes Online is the only authorized note-taking service at UC Berkeley. Do not share, copy or illegally distribute (electronically or otherwise) these notes. Our student-run program depends on your individual subscription for its continued existence. These notes are copyrighted by the University of California and are for your personal use only. D O N O T C O P Y Sharing or copying these notes is illegal and could end note taking for this course. LECTURE UNCERTAINTY We have a lot of stuff to cover today. We haven't talked about the element of certainty at all yet. It's as if when people buy inputs they already know how much they will make. The problem is we have to make decisions now whose outcome depends on unknown events in the future. An example is the job market; you choose a career now, but you really don't know how the job market will be. You think if you're a programmer you'd graduate and make loads of money, but there could be a recession. When you buy a house you have to buy some kind of insurance because there could be an earthquake. We can take actions that change the level of uncertainty we face. If you buy a house you face a risk, but you can reduce the amount of risk by buying insurance. Or you can increase the amount of uncertainty, as with gambling. Another way, which is more common, is to either keep your savings in a bank account or put it into the stock market. There's a lot of uncertainty about what the result will be, but you have a greater chance of a higher return. Okay, we want to describe markets created with regard to uncertainty, and how decisions are made, focusing on insurance . Insurance reduces the level of uncertainty. That's the topic for today. There are really two concepts going on: a new form of utility function, called a Von Neumann- Morgenstern utility function that is good for examining uncertainty. And secondly, expectations for uncertain, future events: I. VON NEUMANN-MORGENSTERN UTILITY Okay, so what's Von Neumann-Morgenstern? You can define utility , normally, as the amount of happiness you get from consuming a certain level of goods. This is a different utility function; it defines utility through your total income, wealth, or assets: Generally it states that the more money you have, the higher utility you will have. You'll be better off and you will be happier. In this model, utility is a function of the amount of income you have got; it implicitly assumes you will allocate that income to
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ECONOMICS 1 ASUC Lecture Notes Online: Approved by the UC Board of Regents 10/22/08 D O N O T C O P Y Sharing or copying these notes is illegal and could end note taking for this course. 2
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10.22.08 - ECONOMICS 1 Professor Kenneth Train 10/22/08...

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